The Credit Crunch

by J. Orlin Grabbe

A credit crunch happens when you go to the bank and
can't get a loan, even though your personal
circumstances have not materially changed from the time
loans were available.

A credit crunch happens when you have existing credit
lines at a bank, and these lines are suddenly withdrawn
or contracted, particularly just when you need them.

A credit crunch happens when a company goes to the bond
market to issue bonds, and suddenly finds that the
interest yield that will be paid on these bonds must be
radically increased, or, equally likely, that there is
no market for the company's bonds at all.

A credit crunch happens when financing for real estate
transactions disappears or is hard to find. Since
financing is a significant component of demand, the
price of real estate drops quickly.

A credit crunch happens when commodity financing is
withdrawn, so that inventories of, say, nickel, copper,
crude oil, or silver can no longer be carried. The
inventories have to be rapidly liquidated--sold in the
market--with a consequence depression in the price.

A credit crunch happens when the collateral posted in a
loan or trade transaction suddenly drops in value, so
that more collateral must be posted. When this is not
possible, the collateral must be sold at its new low
price in order to help repay the loan. Done in
sufficient volume, this further depresses the value of
the collateral.

Differing Origins of Credit Crunches

There are many different reasons a credit crunch can
take place:

1. The central bank can suddenly cut back on the
amount of reserves available to the banking system,
with a consequent contraction in banks' ability to
make loans. This is what happened in the US in 1979-80
and in Japan in 1989-90. Central bank credit
contraction is not, however, a significant factor in
the US or Europe in October 1998.

2. There can be bank failures due to bad loans,
creating perceptions of increased risk, which causes
other banks to tighten their lending criteria and to
restrict credit. (Even in good times, bankers prefer to
lend money only to those who do not need it.) Risk-
related restriction in bank lending has been widespread
in Southeast Asia throughout 1998.

3. There can be bond defaults, which causes credit
spreads to widen. Interest yields on lesser grade
corporate bonds and asset-backed securities increase
dramatically, in a "flight to quality". The flight to
quality takes the form of a dash to purchase government
bonds, believed to be risk-free. Thus the diminishing
supply of capital is further depleted as it becomes
available for immediate government consumption. The
Russian government default in August 1998 led to a
dramatic widening of credit spreads as investors and
portfolio managers dumped corporate bonds,
convertibles, asset-backed securities, and junk bonds,
and dived into US Treasuries. This widening of spreads
drove one hedge fund, Long-Term Capital Management,
into near default, after its capital fell from $3.7
billion to $600 million following the Russian
government default and the ruble devaluation.

4. There can be a credit crunch because of panic
disintermediation. Panic disintermediation is the
dumping (rapid sale) of securities, commodities, and
other assets in a scramble over possession of the
limited supply of money (cash). This happened in
October 1998 as US Treasuries were sold for cash, and
the yield shot up from 4.73 to as high as 5.20 over a
two day period (Oct. 8-9). Portfolio managers were
telling investors, and each other, that being out on
the long end of the yield curve was the best hedge
against a downturn in the world economy. It took only
48 hours in the real-world classroom for them to learn
differently.

5. There can be a credit crunch because of a run on
the currency. This source is actually the same as that
of 4., the only difference being that there is panic
liquidation of financial assets in one currency, in
exchange for cash in another currency. This happened
in October 1998 as the yen rose in value from Yen
131/dollar to Yen 111/dollar in less than two days
(Oct. 7-8). The dollar had become less attractive
relative to the yen: the Fed cut the discount rate,
hedge funds unwound short yen positions, and Japanese
banks and other financial institutions dumped dollar
securities because they needed the capital at home
(especially after the Nikkei 225 dipped below 13,000).
Normally this degree of price movement is only seen
under fixed exchange rates, at a time when a fixed rate
breaks down. However, in this instance, the common
expectation that the yen would continue to depreciate
to Yen 160/dollar acted as an anchor to fix the yen's
value at a relatively low level. Borrowing in yen at
extremely low interest rates was considered a free
lunch. Then one day the free lunch disappeared. Tiger
Management, a hedge fund which had been borrowing in
yen to buy dollar assets, suffered a loss of almost $2
billion on Oct. 7 due to the surge in the Japanese yen
against the U.S. dollar. That was about 9 percent of
the fund's value.

Securitization

Credit crunches used to be banking phenomena almost
exclusively. No more. During the 1980s and 1990s
formerly illiquid assets became more marketable or
tradable. They no longer just sit on the asset side of
some bank's balance sheet.

"Securitization" is the process by which a collection
of receivables is put together in a package, and then
bonds are issued against the package. The package may
be a collection (or portfolio) of credit card
receivables, or automobile lease payments, or
commercial mortgages, or some similar type of asset
which provides "backing". Payments made to the owner
of the packaged assets are then passed along, in part,
as interest and principal to the bondholders. The
bonds (which may have various strange and wonderful
names, such as "CMOs"--collateralized mortgage
obligations) trade in a secondary market, so the whole
process has turned fairly illiquid items (the original
credit card payments, or whatever) into tradable
securities.

The term "disintermediation" is also used, meaning that
banks (or other financial intermediaries) are no longer
the direct lenders, but rather bond purchasers become
the direct lenders. Repayment to the bond investors
depends on the good credit of those making payments
into the asset pool (of commercial mortgages, or
whatever), so that the interest payments on the bonds
reflect a "credit spread" over some benchmark bond
interest yield, such as the interest yield on US
Treasuries. In the first half of 1998, more credit was
provided in the asset-backed securities market than
provided by the entire US banking system.

Thus the bond markets immediately reprice credit
spreads, and there is nothing the Federal Reserve can
do about it. (It would be even worse if there were no
securitization and all capital flowed instead through
the banking system. For in that case, an attempt to
"hold down" credit spreads would simply result in
credit rationing: some entities would get credit, and
others would get nothing.)

The bottom line is no one is in charge, and mommy can't
take the hurt away. The globalists fanatically deny
this, saying, "We are in charge; or else, we would be,
if only you would give us more money for the IMF, for
the World Bank; if only you would do these new and
wonderful things like open the Federal Reserve spigots
or create an `international' lender of last resort,
etc., etc." Yes, all the globalists will become Big
Swinging Dicks if only you gave them a few billion
dollars to play with. Meanwhile, the conspiracy
theorists say, "Some secret group is causing all this
financial turmoil," and can't figure out why the likely
suspects seem so disarrayed. Both groups believe the
world is a giant machine, and just by turning this or
that dial, or squirting a little oil here or there, or
replacing the engineer, we can put everything right
again.

Long-Term Capital Management

John "Liar's Poker" Meriwether's Long-Term Capital
Management (LTCM) was down 44 percent in August 1998.
The former Salomon bond trader had as partners option
gurus (and Nobel-prize winners) Robert Merton and Myron
Scholes helping him run the fund, along with other
trading stars who even took out personal loans to
increase their own exposure to the firm. Three LTCM
partners took out personal loans of $34 million from
the hapless Credit Lyonnais to plow back into LTCM
(Credit Lyonnais proving once again the Dylan dictum
that just when you think you've lost everything, you
find you can always lose a little more).

As for the three partners, finance theory says don't
invest in the stock of the company where you work. For
the obvious reason that if the company falls on hard
times, the stock will likely be taking a hit just as
you are being fired. But True Masters of the Universe
don't bother with such trivial notions of
diversification. They prefer a Texas Hedge: go long
two call options and buy the underlying asset.

UBS (the largest European bank, which resulted from the
merger earlier this year of Union Bank of Switzerland
and Swiss Bank Corporation) had a realized loss of $705
million due to its exposure to LTCM and fired its
chairman. The bank had a policy of not making loans to
entities with leverage (the ratio of assets to capital)
greater than 30. But its own private estimate of
LTCM's leverage was 250, yet it loaned them a lot of
money anyway. (LTCM had not one, but two Nobel prize
winners as partners.) The 250 number may be too high,
but what it means is that for each $1 in capital, LTCM
put the equivalent of $250 at risk, through a
combination of borrowed money and derivatives. Clearly
UBS had faith in LTCM, as did the Bank of Italy, and
many New York firms such as Chase and Goldman Sachs.
LTCM had profits of 43 percent in 1995 and 41 percent
in 1996.

At the beginning of 1998, LTCM had $4.7 billion in
capital. LTCM has dozens of trading strategies, none
of which is public information. But it is clear they
like to deal in bond credit spreads. They had several
bets that credit spreads were going to narrow. So they
were long commercial-mortgage backed bonds and junk
bonds, and short US Treasuries. They also expected
credit spread narrowing in Europe because of the
interest rate convergence required for the introduction
of the Euro. Hence LTCM was long Italian government
bonds, and short German government bonds. The fund had
a bad month in June, when the fund was down 10 percent.
But in July the IMF saved Russia. And as of mid-August
LTCM still had $3.7 billion in capital. Then Russia
defaulted, and credit spreads widened greatly. US
Treasuries soared in price, as did German government
bonds, and lesser credits took a dive. So did LTCM. The
fund was down 44 percent in August, and its capital had
dropped to $600 million by mid-September. The final
straw in September seems to have been the unraveling of
a stock bet that the merger of Ciena and Tellabs would
go through.

Warren Buffet offered to buy LTCM, and its alleged $600
million in capital, for $250 million (showing that
Buffet didn't believe the $600 million figure), with a
plan to recapitalize the firm with $4 billion or so.
But Buffet's offer had a catch: Meriwether would get
fired. Buffet was turned down. The Fed rounded up
some of the current bank lenders to LTCM, who kept
Meriwether on and agreed to recapitalize the fund
themselves on Sept. 23.

The US Congress afterward held hearing whether hedge
funds should be regulated (just which genius are they
going to get to do this job?--maybe Merton and Scholes
are out looking for work?). Many people were upset
because LTCM was "bailed out" without anyone being
punished. But what is easily overlooked, however, is
that LTCM was bailed out because of regulation. The
Federal Reserve convened a consortium of banks who
provided the infusion of capital. (LTCM partner David
Mullins Jr., a former Vice-Chairman of the Federal
Reserve Board, knew just who to call.) The banks could
hardly refuse to show up, for they are, after all,
regulated by the Fed. So they poured another $3.65
billion of capital into the LTCM capital destruction
machine. And why not? It was only depositors' money,
and those deposits are insured. The risk of repaying
bank depositors is carried by the FDIC. So why not
invest in a hedge fund which is leveraged 250 to 1 (or
is it only 100 to 1)? If LTCM is lucky, the bank will
make a lot of money. If LTCM is unlucky, the FDIC pays
the piper. The system is good. It's win-win for the
banks.

The International Lender of Last Resort

Alan Greenspan says that what is happening in
international financial markets is unlike anything he
has seen in 50 years.

So what is he going to do about the credit crunch? Not
much, I expect. In traditional central banking theory,
the lender of last resort--the Federal Reserve, in
this case--is supposed to halt the run out of
relatively illiquid financial assets, and real assets
(commodities, goods) and into money. How? By making
more money available. One deals with the drying up of
liquidity by creating more. But how does one do that
without exacerbating the current problem, or simply
creating future inflation? Who should get money, and
why? Doesn't postponing liquidation of assets postpone
resolution of the crisis?

But . . . moving along. Lenders of last resort--
whatever their supposed merits--respond necessarily to
domestic considerations. So suddenly we are now
witnessing a rash of proposals for an "international"
lender of last resort, which will act from global
motives, and not be bound by petty domestic
considerations.

The international lender of last resort is a deus ex
machina that will somehow operate outside the world
financial system to save the system from crisis. (For
if the international lender of last resort is part of
the system, then in what sense can it itself be exempt
from crisis?)

Policy makers, who haven't a clue as to how to deal
with the world financial crisis, are now being given a
"solution" by economists--or whatever it is that people
at the US Treasury call themselves--who are equally
clueless, but who have seized on "international lender
of last resort" as a counterfactual offering to policy
makers: "Oh, what we need is an international lender
of last resort." Since we don't have such a lender,
the suggestion is nonfalsifiable, much like those
historical arguments which say, for example: "If only
Napoleon hadn't invaded Russia, then blah, blah, blah
[make up whatever story you want to, because since
Napoleon did invade Russia, history can't refute what
you say]."

Where would an international lender of last resort come
from, with no world government, no world central bank,
and no universally recognized system of laws? And who
wants any of these, anyway?

The analogy is with a domestic lender of last resort,
such as the Federal Reserve. Now, there is no
evidence that the Fed has prevented any financial
crises--or, net net, prevented any more crises than it
has generated. But all that doesn't matter: the very
"experts" consulted are from the US Treasury, the
Federal Reserve, the IMF, the World Bank--and they
(surprise) uniformly see the need for a greater role
for themselves and for people like them.

Many see the IMF evolving into just that "international
lender of last resort" role. Then the new mega-IMF can
do for the global economy what the IMF recently did for
Indonesia and Russia.